Why the EU Banking Union Won’t Work for Long
Banks are economic profit driven entities taught to perform in a competitive environment. Business agents cannot act lawfully in a predetermined and heavily regulated environment without seeking new niches and innovative business lines. Historically, money lenders and banking establishments have lent money to all kinds of borrowers and have financed various activities. Banks always dealt with regulators in such a way that their gains would not be affected. Players may cooperate in a competitive environment for their own common interests but solidarity is not the name of the game. An over-regulated economic sector cannot produce substantial profits and social benefits for long.
The financial crisis was attributed to a loosely regulated global financial, especially in the area of investment banking. The USA subprime loan crisis from 2007 and the overgrown derivatives markets were considered to have ushered the crash of the global financial system from September 2008. Other suggested roots of the crisis were the knotty entanglement of investment banking and speculative markets.
The EU was quick to consider that a wave of new regulation must be ensured for the banking sector within the continental bloc, especially for the euro-area. The confessed purpose of such new regulation was to insure the stability of the euro currency and that of the euro-area as a whole.
The EU was quick to consider that a wave of new regulation must be ensured for the banking sector within the continental bloc, especially for the euro-area. The confessed purpose of such new regulation was to insure the stability of the euro currency and that of the euro-area as a whole. A common framework of laws and norms was necessary for the banks and lending companies operating in Europe. The idea was not new – it was only the right time to pursue it.
The integration of bank regulation has long been sought by EU policymakers, as a complement to the internal market for capital flows and, later, of the common currency. However, the willingness of member states to retain instruments of financial repression and economic protectionism led to the failure of a common European framework for banking supervision within the EU. The expanding global economy and the emergence of pan-European banking groups led to renewed calls for banking policy integration, not least by the International Monetary Fund, the OECD and the G20 finance ministers.
The deterioration of lending conditions during the economic crisis and the spread (contagion) of financial instability to the euro-area caused renewed thinking about the interdependence between banking policy, financial integration and financial stability. A resolution of the European Parliament stated that "ensuring a well-functioning EMU [Economic and Monetary Union] implies strengthening banking supervision and resolution at European level". By late 2014, the legal framework and the institutional mechanisms were put in place for the inauguration of the EU Banking Union which came into effect in 2016.
However, this Banking Union project should not be distinguished from the broader EU efforts to accelerate the integration of the Economic and Monetary Union (EMU) main branches: the single-market, the key sectors of the real economy, the financial-banking sector (implying the banking, shadow banking and the capital markets) and the common fiscal-budgetary framework, prompting the enhanced macroeconomic governance framework. The main picture was that of a fully integrated economy for the euro-area member states, coordinated by EU institutions and based on more generous sovereignty sharing by member countries in Brussels’ favor.
We argue that the intention to expand the regulation framework for the financial services sector was there for a longer time and that the crisis served merely as a convenient reason for EU policy makers to proceed firmly in this regard.
What is the Banking Union and how does it function
The formal “definition” of the Banking Union is that of an essential complement to the EU Economic and Monetary Union (EMU) and the internal market, which aligns responsibility for supervision, resolution and funding at EU level and forces banks across the euro-area to abide by the same rules. It is stated by the EU official documents of reference that these rules ensure that banks across Europe take measured risks, and that a bank that errs pays for its losses and faces the possibility of closure.
Supervisory responsibilities were granted to the ECB (European Central Bank) and new mechanisms were set up. A comprehensive assessment consisting of an asset quality review and stress tests were conducted prior to entry into force of the specific mechanisms. Over the course of 2015, all banks had to submit capital plans to the ECB showing how they intended to address various gaps.
The Banking Union comprises two major elements: the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). The SSM supervises the largest and most important banks in the euro-area, while the purpose of the SRM is to handle failing banks in an orderly manner. Both have become operational in recent years. A third element, a European Deposit Insurance Scheme (EDIS), is being currently debated, but does not seem very successful thus far.
Additionally, the new Bank Recovery and Resolution Directive (BRRD) from 2014 provides ways in which ailing banks can be salvaged without requiring bailouts, implementing the principle that losses have to be incurred first by shareholders and creditors, rather than through state (public) bailout funds. Moreover, only insured deposits are totally excluded from the bail-in scheme. Only after an 8% amount is bailed-in from shareholders and creditors can the resolution fund, to which the banking sector contributes, take part in the process and for a maximum amount of 5% of total liabilities (including own funds) of the bank under resolution.
Regarding the issue of minimum capital requirements, two specific acts transposing the prudential capital requirements for banks into European law, the updated Capital Requirements Directive (CRD) and the Capital Requirements Regulation (CRR) entered into force by 2014. There is also a Single Rule Book applicable to all banks in the EU with the purpose of generating the even level playing field within the single market.
Nonetheless, this complex ensemble is still considered as incomplete. The European Commission has vowed to draft complementing legislative acts (so-called level 2 measures) that specify certain technical details currently missing. In 2016, a new comprehensive package of reforms meant to amend the rules set out in the CRD and the CRR was put forward.
The Banking Union is a supervisory and recovery (resolution) mechanism for larger banks in Europe, including a common scheme for guaranteeing deposits.
Basically, the Banking Union is a supervisory and recovery (resolution) mechanism for larger banks in Europe, including a common scheme for guaranteeing deposits. Its first goal is to separate banks from public (government) bail-out funds. Another goal is to overcome financial fragmentation and promote financial integration through the SSM mechanism. The SSM would create incentives for deeper integration of the European banking sector and render the single currency less vulnerable to fragmentation. Therefore, the EU envisions a market-maker role for the Banking Union, thus openly confirming its hidden interventionist role in the still officially “open” market economy of Europe, which is however based on an ever-enhanced regulatory framework.
The EU envisions a market-maker role for the Banking Union, thus openly confirming its hidden interventionist role in the still officially “open” market economy of Europe, which is however based on an ever-enhanced regulatory framework.
The Romanian banking sector, through its regulator – the domestic central bank (NBR) – has been a part of the EU Banking Union since 2014. It was a wise decision by the NBR at the time, even though it was not subjected to Parliament’s approval nor did it follow a public debate in this regard. The domestic banking sector is probably one the best assets of the Romanian economy and it is necessary to constantly secure its competitiveness and trustworthiness within the larger European financial system. Also, in mid-2014, the Government had officially set a date for adherence to the euro-area – 2019. It was more of a public political move rather than a well assumed economic policy decision. It seemed pragmatic to integrate first the national banking sector into the euro-area, respectively in the Banking Union, and gradually integrate the real economy. Subsequently, in 2016, the following cabinet had backed down from this accession date to the EU currency bloc due to insufficient preparation and political consensus for such a major step. Our banking sector remains a committed participant to the Banking Union.
What is EDIS and why it is disputed
Conceding bank deposit guarantee rights to the EU would cut off the last remaining tool of sovereign (national) control over the banking systems of the euro-area Member States. It would practically seal off the Banking Union and it would enable Brussels policy makers to further develop their case for deeper economic integration of Member States under EU tutelage.
In late 2015, the EU has presented the third major piece of the Banking Union complex – a common deposit insurance scheme, namely the European Deposit Insurance Scheme (EDIS), to be built on the basis of existing national deposit guarantee schemes. EDIS would be introduced gradually and would be accompanied by strict safeguards and measures to reduce banking risks. A new deposit guarantee scheme directive (DGSD) would also be adopted in this matter. It was cleverly named “insurance scheme” and not a “guarantee” mechanism as it was certainly meant to be. Conceding bank deposits guarantee rights to the EU would cut off the last remaining tool of sovereign (national) control over the banking systems of the euro-area Member States. It would practically seal off the Banking Union and it would enable Brussels policy makers to further develop their case for deeper economic integration of Member States under EU tutelage.
This is where several Member States disagreed with the European Commission’s plans. Germany, a constant and consistent supporter of the EU project, had a rather unusual position on this matter. The German economy is the main engine of the euro-area, especially since France is affected by the unsettled deficit issue. Berlin is first interested in a comfortable resolution of the sovereign debt issue across the EU. Recently, the Greek crisis has sharpened Germany’s demands for more structural reforms and responsible fiscal policies throughout the Union (i.e.: budgetary discipline). The influential German minister for federal finances, Wolfgang Shäuble, has stated that the proposals regarding EDIS were put forward too early and too soon. According to Dr. Shäuble, EU states must first solve the lingering sovereign debt issue and their deficits; more in-depth structural reforms are needed and further consultations must be carried out for such a common EU deposit mechanism. The hidden explanation would be that Germany is one of the few European countries insuring its depositors via national (local) funds – respectively funds stemming from inside the German economy and domiciled in this country. In short, Germany is reluctant to guarantee Greek deposits in case their national banking sector collapses via a common EU (euro-area) mechanism.
Other European states have backed out from supporting the EDIS proposals. The European Parliament has also displayed a reluctant attitude. It mentioned the need for an impact assessment on EDIS, as well as additional specific steps in the area of risk reduction.
An important industry partner, the European Banking Federation (EBF), representing some 32 national banking associations in Europe of about 4,500 banks, sensing that the EDIS proposals were heading towards an unwanted impasse, adopted a more prudent but detailed stance in its position paper from March 2016 – “EBF position on the European Commission proposal for EDIS”.
While the EBF agrees that an EDIS mechanism is appropriate, the design and timing should be more carefully considered to ensure it follows a strict order of priorities, allowing enough time and being contingent on all participating euro-area Member States overcoming their differences at national level.
The EDIS proposal should be carefully reviewed to take into account the harmonization process within the current legal framework of the Banking Union without compromising best practices and the level playing field in the banking sector. The EBF favors a step by step approach allowing more time and consideration for the subsequent steps. An evolution towards an EDIS should be dependent on certain prerequisite milestones:
- a comprehensive public stakeholder consultation and impact assessment to determine the appropriate design, calibration and evolution of the envisioned EDIS;
- giving priority to achieving a level playing field by further harmonizing banking regulation with respect to implementation of DGSD (Deposit Guarantee Scheme directive) and BRRD;
- addressing remaining significant risks on bank balance sheets in the Banking Union not yet subjected to the ECB’s Asset Quality Review (AQR).
The EBF underlines the issue of costs – respectively, cost neutrality - an essential condition for the political acceptability of the EDIS. According to EBF, there should be no overall increase in individual contributions to deposit insurance schemes. In this regard, the proposed target level in the EU’s directive (DGSD) should be re-assessed, in order to evaluate if a target level of 0.5 % – as already foreseen in the DGSD – may be more appropriate than the current 0.8 % of covered deposits.
The EBF also addresses the issues of the MREL and the TLAC, which are currently at the top of the agenda for central bankers and industry executives. Loss absorbing liabilities (Minimum Requirement for Own Funds and Eligible Liabilities – MREL) under the BRRD and the new standard on Total Loss Absorbing Capacity (TLAC)) and depositor preference enable banks to be handled without any loss to insured depositors or taxpayers. Insured deposits are excluded from and have a super senior status to such resources. Banks placed into resolution would thus have sufficient resources to absorb losses before insured depositors.
If the EDIS proposal were to be implemented without prior and significant amendments and further harmonization of the DGSD, it could generate striking differences among banking sectors in the EU.
Further harmonization is needed to ensure the level playing field within the Banking Union participants and the rest of the EU. The different funding levels for deposit guarantee schemes (DGSs) and different options and discretions in the DGS directive, in the euro-area and the rest of the EU, need to be eliminated with priority where these distort competition in the market and affect the single-market principles. If the EDIS proposal were to be implemented without prior and significant amendments and further harmonization of the DGSD, it could generate striking differences among banking sectors in the EU.
Free market versus over regulation
The European banking sector seems to be the most regulated of all other similar sectors at international level. This happens at a time when the US Trump administration is taking some steps in deregulating their financial sector, such as reducing the famous Dodd-Frank Act from 2010.
Most of EU’s rules are based on the BIS – Basel Committee’s guidelines and on industry standards of the OECD and recommendations of the G20 group. There are various dialogue forums for central bankers and advisory boards for central banks and market authorities. During the financial crisis, multiple government bail-outs of failing financial institutions were carried out in order to prevent financial market meltdown and the spread of contagion within the industry. Even up to this date, in many EU countries, governments use public funds for banking sector bail-outs; fortunately, Romania is not of them. One of the resolution possibilities for ailing banks is the bail-in of debt. This is intended to ensure that higher returns also involve higher (default) risk. The aim is to re-establish market discipline.
Currently, there are two bail-in tools at the disposal of EU regulators –Total Loss Absorbing Capacity (TLAC) and Minimum Requirement for Own Funds and Eligible Liabilities (MREL). Although they share a common objective, they differ in their scope and details. Regulators should try to align both concepts for efficiency reasons.
A comprehensive paper from the Deutsche Bank Research unit shows that any successful application of a resolution procedure requires that financial markets should perceive the resolution framework as credible. Otherwise, resolution could lead to major turmoil, if investors would still expect a government bail-out and consequently misprice the costs of failure.
The bail-in of debt seems to be a major development in dealing with struggling banks, but is this new framework actually credible and subsequently applicable? The substantial issue is who might be the optimal investor for bail-in capable debt instruments and what would be the implications for bank funding costs. As insurance volumes increase substantially, market depth becomes a crucial factor. Outstanding long-term debt securities issued by financial companies from the euro-area have declined sharply since 2012. This trend may be demand-driven or supply-driven; it would be worrisome if it were due to demand constraints. Bank bonds are visibly less attractive for investors. In this regard, recent studies indicate a shortfall of bail-in debt instruments on EU markets.
This trend obstructs an accurate assessment of market depth and does not provide clarity for investors. Currently, industry leaders and regulators are concerned with raising substantial volumes and relevant standards for investors. The European Commission representatives suggested that bail-in instruments should be held outside the banking system, while the Basel Committee does not specifically ban banks from holding bail-in capable instruments. A specific ban for banking sector investors may not be consistent with conventional economic thinking. Therefore, banking resolution regulation put forward recently by the EU is still in empirical stages. Other concerns indicate that, generally speaking, funding costs of European banks will likely mount due to the new MREL rules.
In a free market environment, profit-driven players are not interested in a socialization of profits and a privatization of losses. Rather the contrary. The EU’s Banking Union aims to restore market discipline, improve resilience and sustain an even playing field for the European banking sector (through the SSM, the BRRD, the MREL/TLAC tools). Additionally, there have been plenty of new rules on the fiscal policy side regarding larger multinational companies, with the purpose of combating tax avoidance and harmonizing tax practices throughout the EU. In such an over regulated environment, private entities will inherently be less motivated to participate and will certainly look for various ways to fulfill their own business goals.
The puzzle for Brussels is to reconcile the interests of all or most of its sponsors; such interests may be divergent at times.
The EU is a complex system of rules and policies. For one thing, it caters to its main political and social sponsors – the Member States (via their governmental establishments) and the citizens of Europe. On the other hand, without private sector support, the EU would be less effective in implementing its policies. The puzzle for Brussels is to reconcile the interests of all or most of its sponsors; such interests may be divergent at times. By constantly mulling new regulation, this quest may not be solved successfully or sustainably.
Let no crisis go to waste
By March 2017, the European Commission officially voiced a long awaited attitude towards the EU project – the concept of a Multi-speed Europe. This concept requires consistent debate. It basically implies that the euro-area Member States are to accelerate their economic and political integration, while the rest of the continental bloc would be granted “specific” treatment.
With the mounting uncertainties regarding the EU’s future, non euro-area countries are growing more interested in seeking economic alternatives to EU’s single market – the case of Hungary and Poland, for instance.
What might this spell for the Banking Union? It should spell good news from a technical stand point; however, in real terms, it means a diminished influence over the non euro-area banking sectors. Why would this be? Normally, non euro-area banking systems become inherently influenced by and attracted to the more prosperous euro-area banking markets. Such is the case of Romania, for example. But with the mounting uncertainties regarding the EU’s future, non euro-area countries are growing more interested in seeking economic alternatives to EU’s single market – the case of Hungary and Poland, for instance. Although a more consolidated euro-area should likely influence the rest of the EU Member States into joining the currency bloc, due to mounting frustrations and global uncertainties, the non-euro countries are growing more interested in strengthening their own economies and seeking new markets for trade and investment. The mere fact that the euro-area is becoming more consolidated should not necessarily mean that it becomes an economic and political force to reckon with. The Brexit has just proven that separation from the continental bloc is possible, without major losses so far for neither of the divorcing parties.
A multi-speed EU should not be regarded as a stimulus to quickly hurry towards integration within the single currency bloc.
The non-euro EU countries are viewed by economists as “emerging economies” with rapidly growing markets. These nations may attempt to further strengthen their own economies and export products, explore new markets outside the EU and become even more attractive for euro-area based investors. International investors are already interested in developing their business in these states. This would mean that the major euro-area financial institutions could be more interested in doing business there. Pending a successful combination of political wisdom and cunning negotiations with Brussels, the EU countries outside the euro-area may seek to make the best of their current advantages versus the frustrating EU regulatory burden. These countries are firmly aligned with NATO, maintain a diligent participation at international organizations and have built plenty of bilateral partnerships outside Europe. A multi-speed EU should not be regarded as a stimulus to quickly hurry towards integration within the single currency bloc.
From a geopolitical standpoint, it is clear that the multi-speed Europe project envisions a hidden but politically tangible demarcation line in front of Croatia, Austria and, possibly, the Visegrad group countries.
However, from a strategic long-term perspective, the geopolitical uncertainties rank higher than current economic tribulations. The Middle East is a boiling cauldron. Turkey’s unpredictable actions may stir up further conflicts involving the neighboring states. For this reason, the EU wants complete safety at its southern flank; Brussels needs to rid itself of the refugee crisis and to limit Turkey’s influence in the West Balkans among the local Muslim communities. From a geopolitical standpoint, it is clear that the multi-speed Europe project envisions a hidden but politically tangible demarcation line in front of Croatia, Austria and, possibly, the Visegrad group countries, (author’s note: it is more likely that Hungary will follow its own agenda and will steadily distance itself from the rest of the Visegrad group), thus “protecting” Europe from the geopolitical uncertainties stemming from the Eastern Mediterranean. This new EU orientation might diminish the role of the single-market and could render the euro-area less relevant at the global level. A shrinking “Europe” will result in a diminished stimulus for accession to the euro-area for the rest of the Member States. Therefore, compliance with the EU’s truckload of governance rules would be less attractive to the latter Member States.
Other political constraints may further affect the EU’s architecture in such a way that its current DNA becomes completely altered from that of the Union we enthusiastically joined. A different EU requires a new dogmatic approach and new motivation to promote the European integration project.
 European Parliament, (2016): Banking Union fact-sheet:
 European Banking Federation (March 2016): EBF position on the European Commission proposal for EDIS (November 2015):
 Matthias Mikosek: Free market in death? Europe’s new bail-in regime and its impact on bank funding, Deutsche Bank Research, (April 2016): www.dbresearch.com.
 Niamh Moloney: European Banking Union: assessing its risks and resilience Common Market Law Review, 51 (6). pp. 1609-1670. ISSN 0165-0750, Kluwer Law International, (2014): http://eprints.lse.ac.uk/60572/.